The Standing Senate Committee on Banking, Trade and Commerce has the
honour to table its

FIFTH REPORT

Your Committee, which was authorized by the Senate on Tuesday, November
23, 1999, to examine and report upon the present state of the domestic and international
financial system, now tables an interim report entitled The Taxation of Capital Gains.

Respectfully submitted,

E. LEO KOLBERChair

The Taxation of Capital Gains

Report of the Standing Senate Committee on Banking, Trade and
Commerce

Chair : The Honourable E. Leo Kolber

Deputy Chair : The Honourable David Tkachuk

May 2000

MEMBERSHIP

The Honourable E. Leo Kolber, Chair

The Honourable David Tkachuk, Deputy Chair

and

The Honourable Senators:

Angus

Kelleher, P.C.

*Boudreau, P.C. (or Hays)

Kenny

Fitzpatrick

Kroft

Furey

*Lynch-Staunton (or Kinsella)

Hervieux-Payette, P.C.

Meighen

Joyal, P.C.

Oliver

*Ex Officio Members

(Quorum 4)

Note: The Honourable Senator Mahovlich was a member of the
Committee at meetings at various stages during the course of this study.

That the Standing Senate Committee on Banking, Trade and Commerce be
authorized to examine and report upon the present state of the domestic and international
financial system;

That the papers and evidence received and taken on the subject during
the First Session of the Thirty-sixth Parliament and any other relevant Parliamentary
papers and evidence on the said subject be referred to the Committee;

That the Committee be empowered to permit coverage by electronic media
of its public proceedings with the least possible disruption of its hearings;

That, notwithstanding usual practices, the Committee be permitted to
deposit an interim report on the said subject with the Clerk of the Senate, if the Senate
is not sitting, and that the said report shall thereupon be deemed to have been tabled in
the Chamber; and

That the Committee submit its final report no later than December 31,
2000.

The point I made at the Budget Committee was that if the capital
gains tax were eliminated, that we would presumably, over time, see increased economic
growth which would raise revenues for the personal and corporate taxes as well as the
other taxes we have. The crucial issue about the capital gains tax is not its
revenue-raising capacity. I think it is a very poor tax for that purpose. Indeed, its
major impact is to impede entrepreneurial activity and capital formation. While all taxes
impede economic growth to one extent or another, the capital gains tax is at the far end
of the scale. I argued that the appropriate capital gains tax rate was zero.

(Comments by Federal Reserve Chairman Alan Greenspan in testimony
before the U.S. Senate Banking Committee on February 25, 1997. )

The future prosperity of all Canadians depends on their ability to
adapt to, and participate in, the rapidly changing global economy. The transformation of
the economy is being driven by two major forces: globalisation and new technology.

The integration of international markets is leading governments to
recognise that they cannot isolate themselves from the rest of the world. There is
pressure to harmonise policies and regulations, and there is a recognition of the need to
put into place a tax climate that will allow economies to take maximum advantage of this
new environment.

Second, the basis for growth in the "new economy" is
information technology and human capital. This is changing the way businesses organise and
finance their activities and as explained by Vijay M. Jog, the financial system has to
adapt to this new reality:

"It is undeniable that, to compete globally, Canada must change
its focus from a bricks and mortar industrial base to a knowledge-based economy, where
efficient access to external equity capital is even more important. Traditional sources of
debt financing can effectively finance the purchase of assets that have high collateral
value. These lenders are comfortable with the knowledge that, in a worst case scenario,
they find buyers for the underlying assets of the firms. In a knowledge economy, no such
collateral exists. Assets walk out at 5 p.m.; they are not collateral if they dont
come back the next day. Traditional sources of debt financing are not attracted to
financing this sort of entrepreneurial firm. Worse still, even if lenders wanted to lend
against these "soft" assets, the incentive necessary for a proper valuation
may be absent in a lending environment where the up side returns are fixed, but the down
side risk is not. Although there is no empirical evidence of the potential difficulty
of raising funds for these knowledge-based firms, it is fair to say that a strong IPO
environment may be another necessity for a country attempting to shift to a
knowledge-based economy."(1) [emphasis added]

It is these two features of the modern economy that have led the
Committee to conduct this study of the taxation of capital gains. Taxes on investment
income have a major effect on the functioning of capital markets, and the capital gains
tax is believed to have a detrimental effect on the ability of capital to finance the most
profitable investment opportunities. The capital gains tax has been identified in the past
as a significant disincentive to the supply of risk capital for business start-ups and for
small and medium-sized enterprises (SME). This type of financing is primarily provided by
financially-sophisticated individuals (angels) or venture capitalists who operate outside
of a tax-sheltered environment. Their choices are very sensitive to the rate of tax on
their investment income. And their income is most likely to come in the form of capital
gains rather than dividend income or interest income.

Recently, S. Poddar and M. English have estimated that, in Canada,
about three-quarters of individual personal investment income is held in some
tax-sheltered form (e.g. RRSPs, principal residences, etc.)(2).
Although the use of tax shelters reduces the average tax rate on investment income, the
marginal tax applying to non-sheltered income is quite high, reaching 33% to 50%. Economic
decisions are made, not on the basis of average tax rates but the amount of tax paid on
the last dollar of investment. In Canada, we have very high tax rates on the last dollar
of investment, but we try to reduce average tax rates through RRSPs and measures of that
nature.

The current system of high marginal tax rates is a serious impediment
to the creation of new economic capacity. Investment decisions are distorted, leading to
under-investment in new businesses and mobile productive projects because such
undertakings depend critically on financing by taxable individuals. Perhaps more
important, this system does not recognise its cumulative negative effects on the financing
of SMEs, especially the knowledge-based businesses (the pillars of the new economy) and on
entrepreneurship.

According to Statistics Canada, about 60 percent of the
countrys employment increase between 1995 and 1999, inclusive, was registered by
SMEs. Between the second quarter of 1998 and the second quarter of 1999, for instance,
SMEs created 60.2 percent of the 175,048 new jobs in Canada. (3)

In 1962, Canada undertook an extensive review of its tax system with
the establishment of the Royal Commission on Taxation. On the recommendation of the Royal
Commission, Canada introduced a capital gains tax for the first time in 1972. Since then,
capital gains have been taxed as ordinary income -- originally only one-half of capital
gains were included as income. This inclusion rate was later raised to three-quarters, and
most recently lowered to two-thirds in the last federal budget.

There have been only a limited number of Canadian studies regarding the
possible reduction of the capital gains tax. The Committee felt that it could make a
positive contribution by highlighting and analysing the arguments both in favour and
against a reduction in the taxation of capital gains. The Committee held hearings from
November 1999 to March 2000. It heard from a wide range of witnesses, including academics,
tax experts, economists from private consulting firms, and investment professionals.

This report presents an analysis of the pros and the cons of reducing
the capital gains tax. There are a number of arguments against a tax reduction. These
include: negative implications on the distribution of income, emergence of tax planning
opportunities, and losses in tax revenues. The Committee heard strong evidence in favour
of a tax reduction, however. A lower capital gains tax would improve Canada's
international competitiveness, enhance the mobility of investments, create more wealth,
accelerate business and job creation, and enhance economic activity and productivity.
Overall, it became evident to the Committee that, in the context of the new economy, a
substantial cut in the capital gains tax would increase the prosperity of all Canadians
 those who would benefit directly from such a reduction and those who would benefit
indirectly.

The arguments in favour of lowering the capital gains tax are
primarily economic. They revolve around the enhancement of economic efficiency by
eliminating some of the double taxation of savings, and the reduction in the cost of
capital which would lead to greater investment and capital formation. The economic
rationale for reducing taxes on capital is also conditioned by the characteristics of the
new economy, namely globalisation and enhanced capital mobility. Other countries are
reducing the taxes they apply to capital income and Canada is becoming a high-tax
jurisdiction as a result. These developments cannot be ignored.

The arguments against a significant reduction in the capital gains tax
are based primarily on the grounds that the direct effect of such a reduction has a
disproportionate impact on higher-income taxpayers. In addition, a significant reduction
is rejected by some on technical grounds, citing the fact that any major non-neutrality
will generate substantial efforts at tax planning. This would lead to a reduction in tax
revenues, without necessarily generating the claimed benefits and could lead to wasteful
tax-planning expenditures.

These arguments against a capital gains tax cut must be tempered by the
knowledge that a large and growing proportion of Canadians hold assets generating capital
gains. In addition, if the beneficial economic effects of a capital gains tax are
significant, the indirect benefits would be substantial and accrue to a wide variety of
households, whether they had capital gains income or not. Moreover, given the lumpy nature
of asset dispositions, statistics on the incomes of those with capital gains tend to
overstate their wealth.

Finally, one must recognise a unique element of capital gains taxation
that can have a significant impact on appropriate tax policy. Because capital gains are
taxed upon realisation and not accrual, taxpayers have some discretion in choosing when to
pay the tax. The reversal of this lock-in effect via reduced rates could actually lead to
a short-term increase in tax revenues.

Profound economic and technological changes are taking place around the
world. New capital markets and financial instruments have emerged, and advances in
information and communication technologies are leading to increased integration of
financial markets. As a result, the tax system of any nation cannot stand in isolation
from the rest of the world. Most of the witnesses who appeared before the Committee
raised serious concerns about the international competitiveness of the Canadian tax
system. According to Satya Poddar, the United States is now close to being the
lowest-taxed country in the OECD. Canada is moving from an average-taxed country to being
the highest-taxed country. As a result, the Canadian tax system is no longer
competitive.(4)

Other jurisdictions, including the Nordic countries (Sweden, Denmark,
Norway and Finland), have moved to lower marginal tax rates on investment income.
Previously, these countries imposed very high tax rates on investment income, which led,
in the early 1990s, to a tremendous exodus of capital. The same phenomenon occurred in
Germany. European investors in these high tax jurisdictions were avoiding taxation through
the purchase of Euro bonds and the use of secret accounts in Luxembourg, Switzerland and
offshore jurisdictions. These countries had to significantly reduce their tax rates on
investment income in order to remain competitive with the rest of the world. (5)

According to Allen Sinai, the trend is toward a lower, and in some
cases a zero, capital gains tax in most countries around the world. In 1997, the U.S.
federal tax on capital gains was lowered to 20 per cent (from 28 per cent) for holding
periods greater than one year.

Reuven Brenner noted that financial capital is mobile, and thus
difficult to tax. It tends to flow out of high-tax jurisdictions. This is why tax receipts
from capital gains are relatively small in Canada compared to total tax revenues. (6)

You have now heard from enough experts to realize that capital gains
taxes are a voluntary tax. Most people do not have to pay it. You pay it when you feel
like it, and the evidence is that you feel like it when the [capital gains tax]
rates are low. You do not pay it if the rates are high. It is as simple as that. (7)

For Canada, this is perhaps the most important aspect of capital gains
taxation. A reduction in the rate would enhance international competitiveness, especially
vis-à-vis the United States. As long as marginal personal income and capital gains tax
rates are much lower in the U.S. than in Canada, both human and financial resources will
flow to the United States. (8)

Satya Poddar offered the Committee a practical example of a shift of
income out of Canada and into other jurisdictions. A client came to him saying: "My
Canadian tax is too high. I would like to find low-cost alternatives". The
client's income was then shifted to the U.S. and the taxpayer reduced his taxes by six
percentage points. However, for a benefit of 6% to the taxpayer, Canada lost the full 44%
of that income while the U.S. gained 38%. Not a very good trade-off for Canada. (10)

Vern Krishna also provided the Committee with an instructive example:

Let me read to you an e-mail I received from Vancouver dated
Tuesday, December 7. It says, "Vern, here is what "-- name -- " and I hope
to achieve with an offshore trust. Shelter our shares that will be issued to us in
January. Have them assigned to a trust initially rather than to us. Even if the proposed
federal tax laws come into play, we would hopefully still recognize some benefits to the
taxation issue. My situation is such that I own nothing in Canada and I have no problem
having no ties in Canada." This is the son of a person who lives in Ontario, was born
in this country, his parents and grandparents lived in this country, and yet, as a young
person about 28 or 29 years of age is quite willing to move out of the country. Why?
Because he says, "I will have 2,942,500 shares to deal with in January 2000. That is
why I need to understand what can be done with it." He is afraid that when he sells
those shares and is tied with Canada, he will be taxed on 75 per cent of the gain or
approximately 40 per cent. My job is to get him out of that situation and I will have him
out of the situation by January. Now he is moving to the United States. (11)

In the United States, periods of low effective capital gains
taxation, absolutely and relative to the tax rates on ordinary income, have been
associated with strong economic performance.(12)

Before 1972 [the introduction year of the capital gains tax], Canada
was one of the best performing nations in economic terms. Since that time, the economy has
slipped substantially, relative to the U.S. and many other nations. A substantial cut in
the capital gains tax would be the single most important action that the government could
do to improve the economic well-being of all Canadians. (13)

These sentiments explain, according to Dobson and Soutar, why Australia
recently decided to cut its top marginal capital gains tax from 47 per cent to 23.5 per
cent for assets held for one year, and why Germany has just announced its intention to
eliminate capital gains taxes applying to stock sales by corporations. In Germany,
personal capital gains are already exempted from taxation if the shares are held more than
6 months. (14)

Canada, as with the vast majority of other countries, taxes capital
gains when they are realized, as opposed to when accrued. This creates a well-known
problem, referred to as the "lock-in effect." While this concept is understood
in the context of its impact on government revenues, it also affects investment behaviour.

An investor wanting to sell a portion of his or her assets and reinvest
the proceeds into better performing stocks must pay a tax on the capital gains just to
shift this wealth from one asset to another even though the proceeds are never used for
consumption purposes. Thus fewer funds are available for this new investment, leading to a
lower effective rate of return. As a result, the taxation of capital gains " prevents
the mobility of capital, and generally [...] does not allow capital to move to its most
efficient usage." (15)

Herb Grubel told the Committee that according to some estimates
prepared by the Fraser Institute, revenues from the taxation of capital gains were $716
million in 1992, representing only 0.3 percent of the total tax revenues. Furthermore, it
has been estimated by another source that this number was only $904 million in 1997.(16) The reasons for such low revenues are that the gains are deferred,
or minimized through tax avoidance schemes.

According to Mr. Grubel, "whenever the government passes a law to
fix something, there are always unintended consequences." In the case of capital
gains taxation, the unintended consequence is this lock-in effect. The losses incurred by
the lock-in effect are substantial, and when added to the administrative cost, may be
higher than all revenues to the society from imposing such a tax. (17)

Reuven Brenner deplored the high marginal tax rates on capital gains in
Canada, which he sees as a serious impediment to economic prosperity. The prosperity of a
country really depends on its ability to move funds and labour away from traditional and
unproductive uses to newer and potentially higher yielding ventures. This can only be
achieved through a process of experimentation, coupled with mistakes. Therefore the key to
more prosperity is to enable private agents to freely undertake this process. In private
markets, mistakes are usually corrected rapidly, but "when government errs in its
decision-making about the allocation of human and financial capital relative to private
markets, they tend to persist simply because attention to the mistakes can be diverted in
various ways." A policy of low taxes on capital gains brings more prosperity because
it enables resources to move to the most productive ventures, freely, quickly and at low
cost. (18)

According to John Dobson and Ian Soutar, if the taxation of capital
gains was significantly reduced:

The funds that were locked-in, as well as the additional wealth
created, will go back into the Canadian economy through investment in higher returning
assets, business formation and charitable organisations. These investments, in turn, will
have a positive impact on jobs, productivity and prosperity for all Canadians. (19)

Not all witnesses before the Committee, however, believed the lock-in
effect to be significant. W. Neil Brooks told the Committee that the lock-in effect
applies with much less force in Canada than it does in the United States, because Canada
has a system of deemed realisation at death, ensuring that capital gains are unlocked at
that time. According to Brooks, even if one assumes that the lock-in effect is
substantial, there is no good evidence in Canada that it seriously impedes economic
efficiency:

Inefficiencies will occur only when investors are locked into an
investment, and they have some special knowledge of a more lucrative alternative
investment. Otherwise, the person they would be selling to would make the other
investment. That is, it is difficult to see how capital formation can be affected because
some investors are locked into particular investments. While one investor might be tied
up, it means that other persons who might otherwise have purchased that investment, now
have funds available to use elsewhere. There are always two investors on both sides of a
stock market transaction and while, of course, individual investors have different
aspirations and ability, generally, it is likely that the potential buyers of a locked-in
investment would use their available funds in much the same way as the locked-in investor
would. In other words, one cannot create investment. (20)

The point made by Mr. Brooks might be relevant with respect to
investments in "blue chip" stocks, but it is not relevant in the field of
venture capital, angel investing or new economy enterprises, where the market is
distinctly inefficient  especially in Canada. The investor willing to finance a
bio-technology firm with no revenues, and possibly no product, is quite different from the
investor willing to invest in that firm after it is listed on the Toronto Stock Exchange,
with million-dollar revenues and a proven track record. The "lock-in" effect can
have a significant impact on capital formation in the new economy because it discourages
the transfer of capital from one investor to another as the risk profile of that capital
changes.

Jack Mintz suggested to the Committee that the use of
"rollovers" should be seriously examined as an effective way to enhance the
mobility of capital. Some jurisdictions allow assets to be "rolled over" free of
tax under certain circumstances. This effectively defers the payment of taxes on some
capital gains, even after they have been realised.

In the Canadian system, and in most systems, if I am holding Toronto
Dominion Bank shares, for example, and I sell them to buy Royal Bank shares, I will pay my
capital gains tax on the Toronto Dominion Bank shares, even though I exchanged them for
another form of bank shares. In [some other tax systems], that would be allowed to go as a
deferral of capital gains tax. In my example, the Toronto Dominion shares would be used as
the cost basis for determining the capital gains tax to be paid eventually on the Royal
Bank shares, if they are used for consumption purposes. (21)

A similar rollover provision has been introduced in the last Federal
Budget. This measure allows investors to defer the taxes on capital gains from eligible
small business investments as long as the proceeds are rolled over into another qualified
small business within 120 days of the disposition or 60 days after the end of the calendar
year. Investors are allowed to defer as much as $500,000 annually in capital gains.
However, investments are eligible for this provision only if they comprise newly issued
shares in a small business corporation, with assets not exceeding $2.5 million before the
investment is made and not exceeding $10 million after the investment.

Albert Einstein is said to have quipped that compound interest was the
most powerful force in the world. Even a small annual rate of return can have a dramatic
impact on future wealth because of this compounding.

The taxation of realized capital gains interrupts this powerful effect
because it periodically lowers the principal amount upon which compounding takes place.
(The government recognizes the beneficial effect this has on investors and consequently
does not tax investment income that remains in RRSPs and other tax-assisted savings
vehicles.) Investors who switch assets must seek a substantially higher rate of return
just to recover the principal lost to taxation. This results in a tendency to lock in
investments and therefore impedes economic efficiency. Rollover provisions for capital
gains would alleviate this distortion.

John Dobson and Ian Soutar said that wealth formation is essential for
the creation of new employment in the private sector, and to support economic growth.
However, they contend that the contribution of wealth creation to growth and prosperity is
not given sufficient respect in Canada. As a result, opportunities for economic prosperity
and future tax revenues are foresaken.

[Wealth creation] appears to be a bad term in
Canada, so bad that it is neither used nor discussed. In short, Canadians appear not to
want successful creators of wealth, as Americans clearly do. For example, there are only
five Canadian foundations with assets over $100 million, two of which are institutional.
Bill Gates is a hero in the U.S., but he would not be in Canada. To sell capital gains
reduction, we thus have to substitute a discussion of wealth creation for a discussion of
the positive role of capital on the creation of jobs. Everyone accepts that the creation
of jobs in the private sector requires someone to have capital. (22)

It is well known that savings are a key ingredient for economic growth.
Dr. Allen Sinai estimated that for each dollar of realised capital gains resulting from a
lower capital gains tax, 11 cents is spent over a year and one half. The remainder is
saved via an accumulation of household financial assets or a reduction of liabilities.
This promotes wealth creation. On the other hand, each additional dollar of disposable
income resulting from a general reduction in income tax rates leads to an additional 70
cents of consumption after a year or two. This enhances aggregate demand and possibly
leads to higher inflation when the economy is performing near capacity. Capital gains tax
cuts tend to lead to enhanced capacity rather than directly enhanced consumption. Capital
gains tax reductions clearly increase savings and wealth in greater proportion, and thus
minimise the risk of high inflation. (23)

In part, the greater savings is generated by the increased
income of a stronger economy in response to the reductions in the capital gains tax, but
also is due to the increased flows-of-funds from higher capital gains realizations,
especially at the individual level, some of which go back to the government at the new
lower capital gains tax rate but most of which are available for spending or saving by
individuals and, for corporations, on new investment or in cash flow. The additional
savings generated by increased realizations, both "unlocked" and because of
higher equity market, are mostly saved rather than spent, in a pattern that is different
from the consumption and saving out of changes in marginal income tax rates. (24)

In efficient capital markets, if an external factor causes one type of
investment to become less attractive, and another type to become more attractive to
investors, this shift will be reflected in share prices.

Capital gains taxes influence a firm's cost of capital by changing
the rate of return required by the marginal investor in the firm's equity. If taxes change
the required return, then the price the marginal investor is willing to pay for a share of
the future stream of the firm's earnings will change. Because of this, the capital gains
tax would be capitalized into the price of the share. If personal taxes on the firm's
income are increased (decreased), the price of the share falls (rises). So, the response
of equity prices provides direct evidence of how firm's cost of capital changes with
capital gains tax rates.(25)

If reducing the tax on capital gains provokes a large unlocking of
capital which is then reinvested in "new" investments, the share price of these
new investments would increase to a level that compensates for the entire future benefit
of the tax to the investors. Allen Sinai pointed out to the Committee that reductions in
effective capital gains tax rates on individuals would:

[ ] raise the after-tax return on equity to shareholders and
reduce the after-tax weighted average cost of debt and equity, leading to a higher stock
market as individuals shift investments toward equities, [and] increase household net
worth or wealth. (26)

This means that equity financing is now less expensive for new and more
productive ventures because of higher share prices and thus lower corporate cost of
capital. This general concept is demonstrated in a recent U.S. study which examined the
issue prices of small initial public offerings at the time of the 50% reduction of the
capital gains tax on qualified small business stocks in 1993. The study shows that the
issue prices of qualifying small business stocks after the tax rate change are
significantly higher than the issue prices before the change. The authors concluded that
"nearly all of the future tax benefits from the rate reduction were passed on to the
issuing corporations in the form of higher stock prices rather than retained by
investors."(27)

Another study examined the recent U.S. long-term capital gains tax cut,
from 28 per cent to 20 per cent. The study demonstrated that "stock prices moved
inversely with dividend yields during the May 1997 week, when the White House and Congress
agreed on a budget accord that included a reduction in the capital gains tax rate. The
share prices of firms not currently paying dividends increased approximately six
percentage points more over a five-day window than the share prices of other firms. Among
firms paying dividends, the change in share prices was a decrease in dividend
yields." (28)

This shows the relationship between dividend and capital gains income.
If capital gains are taxed less, then companies that distribute a large portion of their
income through dividends are less attractive to investors (this is because the market
value of a company is equal to the after-tax present value of the expected future
dividends plus expected future capital gains). There is thus a greater incentive for
companies to retain more earnings for productive investment (rather than paying out
dividends), which in turn translates into higher after-tax value for their shareholders
and a lower corporate cost of capital (higher market value) for the companies.

The upshot of this is that, while a reduction in the capital gains tax
will provide greater gains to current individual investors, most of the benefit will
accrue to entrepreneurs and businesses via a reduction in the cost of capital. A lower
cost of capital encourages greater investment in plant, machinery, research and
development.

Margo Thorning told the Committee that the capital gains tax
significantly affects entrepreneurship and new business start-ups. She cited evidence from
a range of studies by Professor Wetzel at the University of New Hampshire and a survey by
Stephen Prowse at the Federal Reserve Bank of Dallas, both of which suggest that a
significant portion of seed money for new businesses comes from taxable individuals. For
them, the rate of tax significantly influences their investment decision(29).
Reuven Brenner also believed a capital gains tax cut would stimulate investment in new
businesses. Professor Brenner suggested that a corporate tax cut would yield similar
results. However, capital gains have the additional advantage of promoting innovations,
and investments in new ventures because it directly affects angel investors. What a tax
cut on personal or corporate income cannot achieve as effectively as the capital gains tax
cut is to speed up the flow of private equity financing, which often fuels innovation.(30)

Entrepreneurs are provided with an additional incentive to start a
business and nurture it if they reasonably expect that other private investors will be
ready to buy equity in the firm at an attractive price. This is consistent with the
evidence cited earlier that the benefits of capital gains tax cuts accrue to the issuers
of equity shares and not necessarily investors. Moreover, because the principal rewards to
angels and venture capitalists are the capital gains earned on their investment, such
investors would be less concerned about locking-in their investment for a long period of
time if the capital gains tax were reduced, thereby encouraging the development of the
venture capital industry in Canada. Presently the venture capital market in this country
is comparatively underdeveloped.

Allen Sinai predicted that a reduction in the rate of tax on capital
gains would lead to the formation of more new businesses because individuals would be more
willing to undertake the risk associated with start-ups. Indeed, the lower corporate cost
of capital induced by a higher after-tax valuation of equities, increases the after-tax
return on new investments(31). These, in turn, are more attractive to
investors with a tolerance for higher risk.

Reuven Brenner stressed the importance of the "vital few." It
is mainly those few extremely successful individuals and ventures that bring about
prosperity and increased productivity in an industry, a firm, or more generally in an
economy. A substantial reduction in the capital gains tax will attract and provide more
opportunities for those vital few.(32)

Allen Sinai presented to the Committee the general results of his
computer-model simulations, designed to assess the macroeconomic implications of capital
gains tax cuts. Dr. Sinai described the supply-side effects through which capital gains
tax reductions impacts on the economy:

[ ] New-business incorporations will rise as well with the
increase in economic activity and the increased incentive effects that come from lower
capital gains taxes. There is a supply-side entrepreneurship effect. Jobs are increased,
along with earnings and corporate profits leading to increased consumption and greater
economic activity. That, in turn, induces more spending on consumption and investment, and
increases expected future earnings in stock market valuations. That reduces further the
cost of capital, inducing more entrepreneurial effort. This is the simultaneous set of
interactions and the virtuous circle which goes on from reductions in capital gains taxes
on individuals mainly and, to some extent, on corporations as well. (33)

A tax reduction encourages capital formation. This occurs because of
the reduced cost of capital and the enhanced willingness to invest in riskier projects.
The lower cost of capital, in turn, promotes capital investments and stimulates the market
for Initial Public Offerings (IPO). These effects, along with more risk taking,
entrepreneurship, innovation and the transfer of funds from the "old economy" to
the "new economy" will lead to productivity gains. These increases are small to
modest in magnitude, but definitely significant in any particular year. However, the
impact of capital formation and productivity enhancement is cumulative, so that even small
annual increases can have a dramatic impact over time.

Reuven Brenner explained the determinant of low capital gains taxes on
the development of more entrepreneurship, new capacity and new investments, which lead to
gains in productivity. Mr. Brenner argued that the provincial and federal governments
today try to compensate for the very high capital gains tax by subsidizing various
ventures. However, very few of them are commercial successes, although many extremely
successful ventures originated from private equity financing. Possibly, government
subsidization is just a pure transfer of wealth, one that does not create wealth. It is
not the quantity of jobs that matter the most, but really the quality of the employment.
The government has the power to provide full employment, but if everyone is shovelling
snow with a spoon there is not much wealth created. A policy of low taxation of capital
gains brings more prosperity because it creates an environment for competitive businesses
to flourish, for attracting foreign savings and for the creation of more quality
employment. (34)

What Allen Sinai and others have shown is that it is crucial to
consider the behavioural change of taxpayers in evaluating any tax policy.

Professor Jim Mirlees of Oxford University received a Nobel Prize in
economics for his work on the optimal level and structure of taxes. This work showed that
all taxes induce people to change their behaviour to minimize their payments. Some taxes
do so more than others. All such changes in behaviour lower economic efficiency and
therefore the level of income. (35)

According to Herb Grubel, OECD estimates of the distorting effect of
different classes of taxes on economic activity demonstrate that the real output loss from
an extra dollar of corporate income tax is about three times higher than from an extra
dollar of personal income tax, about six times higher than from an extra dollar of payroll
tax and about ten times higher than from an extra dollar of sales tax.

Therefore, the corporate income tax has the greatest distorting impact
of any tax. The capital gains tax is very similar to the corporate income tax since it
falls on investments and capital. In essence, this corroborates the effect captured by
Allen Sinais model.

Most of the witnesses noted the importance of the neutrality criterion
in the design of the tax system. The argument is that preferential taxation of one form of
return from capital (for example, if capital gains are taxed significantly less than
dividends or interest), could lead to misallocation of resources and distort economic
behaviour leading to excessive investment in one type of asset.

Satya Poddar maintained that the taxation of capital gains should be
viewed in the broader context of taxation of all capital income. Capital income can arise
in the form of interest income, dividends, and capital gains. In designing the taxation of
capital gains the most important criteria is tax neutrality. If some types of investment
income are taxed at preferential rates, it will lead to distortions and tax planning
opportunities. Therefore, if any tax concessions are to be provided, they must be
broad-based and not selective. Moreover, the justification for reducing or removing
capital gains taxes is equally applicable to other forms of capital income(36).
From an economic point of view, most studies indicate that there are large efficiency
gains to be achieved by moving away from a tax on capital towards a tax on consumption.

Jack Mintz told the Committee that non-neutrality leads to considerable
effort and resources being devoted to tax avoidance measures, such as the conversion of
business income into capital gains. He insisted that a differential in the tax treatment
between capital gains and other types of income should be avoided.

[ ] prior to 1972, Canada did not have a capital gains tax.
People would try to convert dividend income into capital gains income that would not be
subject to taxation. This was referred to as surplus stripping. As a result, the main
reason Canada went to taxation on capital gains in 1972 was to create some balance and
efficiency in the system, as well as to minimize the compliance and administrative costs
of trying to run a system with differential tax rates on income and capital gains. (37)

In that sense, W. Neil Brooks stressed that taxing capital gains at the
same rate as ordinary income adds simplicity to the tax system.

Indeed in the United States, it has been argued that giving capital
gains preferential treatment is the single factor that most complicates the tax system and
leads to all sorts of transactional waste in the economy. (38)

Finally, John Dobson and Ian Soutar provided a critical and opposing
view regarding the importance of tax neutrality.

Ottawa and academic economists put too much weight on the technical
issue of the tax relationship between capital gains, dividends, and the small business
tax. In the world of public investors, this is not an issue. While many people argue for
capital gains preferences, and even support lowering the tax to zero, few have grounded
their case on the fundamental principle that capital gains are not income. They should
make this argument consistently because it raises the case from the realm of political
expediency, or even economic efficiency, to the level of principle. Doing so at least
gives advocates of lower capital gains taxation a firmer foundation when confronted by
those making a principle argument for not doing so on the grounds that the capital gains
should really be taxed like ordinary income. (39)

According to Herb Grubel, shares bought 30 years ago in an average
representative company on the Toronto Stock Exchange would have increased in value at the
same rate as the increase in consumer prices. In real terms there is no gain. Yet the
taxation of capital gains does not recognise this  taxing these illusionary gains
effectively becomes the confiscation of wealth.(40) Although most
witnesses recognised the impediments to wealth creation of not indexing capital gains,
they also acknowledged that such indexation would be hard to implement. Most countries do
not adjust the tax treatment of capital gains for inflation, and the few countries that
did are now reversing that because of the technical difficulty in carrying out indexation.

Jack Mintz made another important comment, suggesting that the current
tax system discriminates against savings compared to consumption.

When a person earns income, they pay tax on wages and salaries. If
they consume the remainder of income right away, they will not pay further tax, at least
not under the income tax. However, if they put their money into a bank account or into an
equity share, and they earn income, either capital gains, interest income or dividends,
they will pay tax on that income. They are paying additional tax on their savings.
Therefore, savers are discriminated against under an income tax compared to consumers. (41)

This is referred to as the double taxation of savings ¾ it is not unique to the taxation of capital gains but the taxation
of any return from capital. In other words, the deferral of consumption is subject to tax
in a way that current consumption is not. Double taxation can also occur because of the
lack of full integration of corporate and personal income taxes ¾
income earned on assets is being taxed first at the corporate level, and then at the
personal level. Canada has partially recognised this problem, and has introduced
integration mechanisms for corporate and personal taxes.

Finally, there is an element of double taxation when the income from
assets is taxed along with the capital gains on those assets. Asset values reflect
expected returns. A capital gain is largely based on an expectation of higher future
returns  it can be thought of as the present value of those increased returns. If
the returns are taxed, a capital gains tax constitutes a second tax on the same income.

The treatment of capital gains losses also has an impact on the
effective capital gains tax rate, according to Jack Mintz. The problem is that, in Canada,
capital losses do not receive the same treatment as capital gains ¾
the losses are only deductible against current or future capital gains, and are carried
forward at a zero implicit interest rate. The losses would bear an equivalent tax
treatment as capital gains if they were fully deductible against any current sources of
personal income.

[ ] the lack of full loss-offsetting can result in effective
tax rates being much higher on risky investments than on those that are risk free.
For example, suppose an asset with a certain 10 percent before-tax rate of return yields 5
percent after taxes. The effective tax rate is 50 percent. But if the asset is risky and
losses are not shared by the government, the effective tax rate can be much higher.
Suppose, for example, an asset with an uncertain rate of return has an expected before-tax
rate of return of 10 percent  the average of 30 percent in a "good" state
of weather and 10 percent in a "bad" one, each state with an equal chance
of probability. Given a 50 percent tax rate and assuming the government does not share any
value of the loss, the after-tax rate of return in the good state is 15 percent, but in
the "bad" state it remains 10 percent. The net-of-tax expected rate of
return is therefore only 2.5 percent (= [15 % + 10 %] x 50 %), which implies an
effective tax rate of 75 percent! Risky assets can be highly penalized under a tax system
in which losses are not fully shared with the tax authority.(42)

[ ] the government may allow you to write off the losses over
time, and that is only if you have future gains. There is a time value loss associated
with an inability to achieve a complete write-off of those losses right away. Thus the
capital gains tax actually discriminates against risk-taking and entrepreneurship. This is
one reason for lowering the capital gains tax rate.(43)

W. Neil Brooks told the Committee that the preferential treatment of
capital gains (at the time, a 75% inclusion rate) is unfair and inequitable. Professor
Brooks based his argument on the principle that taxpayers with the same ability to pay
should pay the same amount of tax, no matter how the income is earned. Therefore, all
sources of income should be fully taken into account when determining the tax base,
including capital gains. This argument has been given the popular expression "a buck
is a buck." This ensures that no individuals or groups receive preferential tax
treatment relative to others who have the same ability to pay.

This is the very ethical foundation of having an income tax system
in the first place. (44)

The tax treatment of capital gains has important implications for the
progressivity of the tax system. Most of the capital gains reported each year are earned
by tax filers in the higher-income tax bracket.

The preferential tax treatment for capital gains benefits high
income individuals almost exclusively. In 1996, the average person who earned between
$20,000 and $40,000 reported capital gains of $150. The average person who earned over
$250,000 reported on average a capital gain of $74,000. That is to say that high-income
taxpayers on average earned about 500 times as much capital gains as middle-income
taxpayers. (45)

This argument was refuted by a number of witnesses. Vern Krishna
reported that in 1997, although only 17 percent of individuals with capital gains were in
income brackets above $70,000, 37 percent of the value of the gains accrued to individuals
with income more than $250,000.(46) Herb Grubel argued, however, that
this is a misleading figure because realised capital gains are included in income.
Consider, for example, someone earning below $50,000 annually but who saves a portion of
income in equity shares over a 30 year period, or small business owners who depend on the
future proceeds from the sale of their business for retirement purposes. When these assets
are sold, the individual might realise a substantial amount of capital gains, which would
considerably boost reported income for that particular year. Fifty one percent of all
capital gains taxes are paid by taxpayers earning less than $50,000 on average. The income
of these taxpayers looks high in the years in which capital gains are reported because of
the infrequent impact of capital gains realisations(47). Vern Krishna
referred to this as the "bunching effect", which he believes is skewing the
above figures. Furthermore, Professor Krishna pointed out that the bunching effect
sometimes works against the progressiveness of the tax system:

The bunching effect means that if you buy shares in year one for $20
and sell the shares in year five for $120, the gain of $100 reflects the unrealized
accrual of gains over five years. The triggering event is the sale of the shares,
triggering a realized capital gain. Until that time, the gain is simply accruing and has
no consequences for the taxpayer. This can be unfair to some taxpayers, particularly lower
income taxpayers, because it bumps them from one rate bracket to another. (48)

Allen Sinai told the Committee that there is a widespread belief that
reducing capital gains taxes is somehow unfair, favouring the rich over the poor, and
increasing inequalities in the distribution of income. Mr. Sinai acknowledged that these
arguments have some legitimacy, although every country must decide the weight to be placed
on fairness versus other criteria. Mr. Sinai mentioned that the fairness issue is the only
negative aspect of a reduction in the capital gains tax. (49)

But Reuven Brenner argued that this debate is fruitless and misleading.
Capital is mobile and difficult to tax - it flows away from places with strict constraints
and high taxes to locations where it can freely circulate and grow. This is why capital
gains tax revenues are low: the tax burden effectively falls on the most immobile factors.
Thus the popular claim that the capital gains tax is a tax on the rich is misleading. The
tax is effectively paid by those who cannot move their capital or themselves. Is this
fair?, asked Mr. Brenner. (50)

A reduced capital gains tax will not just help the rich. It will
materially help all Canadians to enjoy a higher standard of living by creating the wealth
that is needed to provide the citizens with better education, health care, or to serve
other collective purposes. (51)

As Herb Grubel pointed out, the first argument for a capital gains tax
is the government's need to raise revenue.

The latest increase to a 75 percent inclusion rate took place when
[Canada] had [a] fiscal crisis in the early 1990s. That is one reason why it was imposed.(52)

Initially, one would argue that a reduction in the rate of tax on
capital gains would lead to a similar decrease in tax receipts. However, the Committee
heard testimony regarding two positive effects contributing to raising more tax revenues.

The first positive effect on tax receipts comes from the one-time
"unlocking" of funds, combined with increased realizations, which would most
likely follow a significant reduction in the capital gains tax.

Margo Thorning reported to the Committee that in 1997, when the capital
gains tax rate was cut in the United States, the U.S. Treasury reported a $16 billion
increase for individual capital gains tax receipts. For 1998, the Treasury estimated a
$4.6 billion increase in capital gains tax revenues(53). These
numbers suggest that a large unlocking of capital investments immediately followed the tax
reduction, leading to strong increases in capital gains tax receipts.

However, Jack Mintz and Allen Sinai agreed that in the long term,
revenues from the taxation of capital gains would decrease.

Overall, from the available evidence, a claim that capital gains tax
cuts will be self-financing in the long run cannot be supported empirically. (54)

Nevertheless, Dr. Sinai is a strong proponent of capital gains tax cuts
because the short-run unlocking of capital gains is so strong that the government gets a
large "bang for its tax cutting buck" that is not found with respect to other
taxes. Despite his optimism, Jack Mintz told the Committee that one should be cautious
when comparing Canada to the United States.

The U.S. experience, as well as studies on the impact of capital
gains taxes on government revenues and the economy, cannot be used in the Canadian case as
easily. The Canadian tax system is somewhat different than the U.S., and this factor has
to be taken into account. For example, if Canada reduces its capital gains tax rates, the
impact on realizations would be different in the United States because Canada has deemed
realization of capital gains at death. (55)

The second positive effect, Allen Sinai told the Committee, was there
would be an indirect increase in overall tax revenues coming from higher spending, greater
employment, income, profits, stock market and wealth. These increases would, at least
partially if not fully, compensate for potential losses in government capital gains tax
receipts in the long run. But most importantly, the positive economic effects of a capital
gains tax reduction are more powerful, per dollar of lost revenue, than for any other
existing tax measure.

More than any other tax policy, capital gains tax reduction has the
best chance at minimizing the loss in tax receipts, net, relative to the gains in economic
activity, entrepreneurship, productivity and potential output. (56)

The Committee heard arguments both in favour and against reducing
or eliminating the capital gains tax. The government must now decide what importance to
give to each of these arguments. In doing so, it is crucial to keep in mind that the
future prosperity of all Canadians depends upon their ability to adapt to global changes
and to build the foundations supporting the "new economy."

Canada has a lot to offer in terms of human capital, entrepreneurship,
ideas, technology and brilliant individuals. For example, the education system in Canada
figures among the best in world. Canada ranks among the world's leaders in per capita
spending on public education. Sixty-seven universities and colleges produce more than
25,000 graduates per year in mathematics, engineering and pure and applied sciences.

A substantial cut in the capital gains tax would enable capital markets
to direct the flow of resources into its most efficient use, providing more opportunities
for talented Canadians to thrive. It would also improve Canadas competitiveness in
international capital markets, creating a favourable investment climate for both foreign
and Canadian investors.

On the negative side, a substantially lower capital gains tax could
lead to tax planning opportunities, and to distortions in the patterns of investment
behaviour. Other costs include a decrease in the progressivity of the tax system and
potential losses in capital gains tax revenues.

Allen Sinai, however, argued that the positive economic effects of a
capital gains tax reduction are more powerful, per dollar of lost revenue, than for any
other existing tax measures. Besides, the gains in tax receipts coming from the cumulative
impact of increases in productivity, entrepreneurship, capital formation and economic
activity could possibly exceed, in the long-run, the losses in tax revenues from the
taxation of capital gains.

Furthermore, when judging capital gains tax reductions, the weight put
on the benefits to economic growth and on international competitiveness should exceed the
weight put on fairness and equity considerations ¾ because of
the resulting job creation and stimulus to the economy, even those who do not benefit
directly from a cut in the tax rate will receive indirect benefits.

This Committee is concerned about the place Canada will occupy in the
"new economy." It is the future prosperity of all Canadians that is at stake. By
maintaining a policy of high taxation of capital gains, Canada is running the risk of
falling behind and declining in economic terms ¾ a situation
where everybody is economically worse off. This Committee believes that reducing the tax
rate on capital gains will result in a richer society that will make all Canadians better
off. A more competitive capital gains tax system will allow Canada to retain its talent at
a potentially zero cost in tax revenues in the long run, with only minor trade-offs in the
progressivity of its tax system.

Recommendation

For all of the above reasons, the Committee believes that a further,
substantial reduction in the capital gains tax rate is warranted. Indeed, as markets for
goods and services become increasingly globalized, and because international competition
for capital rests ultimately on after tax rates of return, Canada cannot ignore
developments elsewhere in the world. Therefore, at a minimum, we recommend that the
Canadian capital gains tax rate should quickly be lowered to match the rate in the United
States. However, this is probably insufficient. A tax rate even lower than the
American rate is more appropriate, as other nations have concluded and as is demonstrated
in Appendix A. Thus, the Committee also recommends that international competitiveness
be the criterion guiding the choice of a capital gains tax regime, and that the federal
government be prepared to lower the tax until that criterion is met.

The federal government has taken some tentative steps in its most
recent budget towards a reduction in tax rates in general and the capital gains tax in
particular. This could be further extended through a combination of reduced personal and
corporate tax rates and a reduction in the inclusion rate to 50 percent, from the current
67 percent. This would bring the Canadian capital gains tax rate into rough parity with
the current American rate.(57)

COMPARISON OF CAPITAL GAINS TAX RATES FOR INDIVIDUALS AND CORPORATIONS

COMPARISON OF CAPITAL GAINS TAX RATES FOR INDIVIDUALS

Country

Individual
Capital Gains: Max. Tax Rate on Equities

Individual
Holding Period

Short-term

Long-term

Argentina

Exempt

Exempt

No

Australia

24.5

24.5; asset cost is indexed

No

Belgium

Exempt

Exempt

No

Brazil

15.0

15.0

No

Canada

32.0*

32.0*

No

Chile

45.0; annual exclusion of $6,600

45.0; annual exclusion of $6,600

No

China

20.0; shares traded on major exchange
exempt

20.0; shares traded on major exchange
exempt

No

Denmark

40.0

40.0; shares valued at less than $16,000
exempt if held 3+ years

Yes, 3 years

France

26.0; annual exclusion of $8,315

26.0; annual exclusion of $8,315

No

Germany

55.9

Exempt

Yes, 6 months

Hong Kong

Exempt

Exempt

No

India

30.0

20.0

Yes, 1 year

Indonesia

0.1

0.1

No

Ireland

20.0

20.0

No

Italy

12.5

12.5

No

Japan

1.25% of sales price or 20% of net gain

1.25% of sales price or 20% of net gain

No

Korea

20.0; shares traded on major exchange
exempt

20.0; shares traded on major exchange
exempt

No

Mexico

Exempt

Exempt

No

Netherlands

Exempt

Exempt

No

Poland

Exempt

Exempt

No

Singapore

Exempt

Exempt

No

Sweden

30.0

30.0

No

Taiwan

Exempt (local company shares)

Exempt (local company shares)

No

United Kingdom

40.0; shares valued at less than $11,500
exempt

The rates vary from 40.0 to 10.0 according
to the number of years the asset is held.
The top marginal rates are 35.0 for one year, 30.0 for two years,20.0 for three years and
10.0 for four years or more the asset is held.

Yes, sliding scale of rates applies to 1
to 10 years of ownership through an exclusion that rises gradually to 75 percent for
assets held 10 or more years. Thus, assets held 10 or more years face a top marginal rate
of 10 percent.

United States

39.6

20.0 (1-year holding period)

Yes, 1 year

*This rate is an approximation, as the rates in Canada vary by income
brackets and by province.

Yes, capital gains from sale of equity
investments and securities listed on stock exchange and held for more than one year are
taxed at 20 percent.

Indonesia

0.1*

0.1*

No

Ireland

20.0

20.0

No

Italy

37.0

27.0 (3-years holding period and applied
on the transfer of shares)

Yes, a substitute tax of 27 percent
applies on capital gains arising from the transfer of shares held and accounted for as
financial assets for at least three years.

Japan

34.5

34.5

No

Korea

20.0; shares traded on major exchange
exempt

20.0; shares traded on major exchange
exempt

No

Mexico

34.0

34.0

No

Netherlands

Exempt

Exempt

No

Poland

Exempt

Exempt

No

Singapore

Exempt

Exempt

No

Sweden

28.0

28.0

No

Taiwan

Exempt (local company shares)

Exempt (local company shares)

No

United Kingdom

30.0

30.0; asset cost is indexed

No

United States

35.0

35.0

No

*Australia: Capital gains tax are now being reduced to zero for
overseas pension fund venture capital investors from the United States, Britain, Japan,
Germany, France and Canada. The zero rate will apply to most situations subject to a
couple of minor anti-avoidance measures. Australia especially hopes to attract venture
capitalists from the U.S.

*Canada: This rate is an approximation, as the rates vary by provinces.

*Indonesia: An additional tax of 0.5 percent applies to the disposition
of founder shares (effective as of May 29, 1997). In this case, if the taxpayer does not
want to use the facility of 0.5 percent, the normal progressive tax rate of 30 percent is
applied.

The statutory tax rate represents the legislated rate of tax, but in some countries
capital gains are indexed to inflation (e.g. Ireland), are subject to other exemptions
(e.g. individuals in France may annually exempt the first US$8,315 in gains from the tax,
while individuals in Germany may exclude all gains from assets held at least 6 months), or
the countries provide other incentives for capital investments. Thus, it is sometimes
difficult to assess the effective tax rate paid on capital invested.

One has to consider that looking at the CGT in isolation from other taxes can be
misleading in some cases. Some countries such as the United States impose an Estate Duty
upon death. Canada does not. Some countries have wide ranging rollover provisions that
allow capital gains taxes to be deferred if the proceeds of disposition are used to
purchase other capital assets. Moreover, one must consider the relationship between the
taxation of capital gains and the taxation of dividend income. Corporations, through tax
planning, can affect the tax rate paid by investors.

For foreign investors, the application of tax treaties also affect investment
incentives. To correctly assess the comparative capital tax advantage of a host country,
one also has to consider the tax rates applicable in the home country and the manner in
which tax treaties are designed.